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Gross: Explaining the Decline of SWFs

Remember sovereign wealth funds? SWFs were the gigantic pools of capital amassed by governments that were export powerhouses (China, Singapore, Korea) or commodity exporters (Saudi Arabia, Kuwait, Persian Gulf sultanates, Russia) benefiting from the boom in global trade and spiking prices. In 2007, after a five-year global expansion, they emerged as a suddenly massive asset class. Morgan Stanley analyst Stephen Jen, one of the first to latch on to their importance, their collective net worth at $2.3 trillion in March 2007 and at about $3 trillion later that year.

The global financial class viewed them with a mix of fear (Oh no! The Arabs and Chinese are going to buy all our strategically important companies!) and optimism (Holy cash cow! A new source of financing and clients for investment banks!). The fact that SWFs operated with all the transparency of a sheet of tinfoil only enhanced their appeal and apparent power. In January 2008, SWFs were the talk of the World Economic Forum at Davos. After all, if the potent economic trends that had made them powers in the first place were to continue, SWFs would only get bigger. (This was another example what I've dubbed "pro forma" disease, the tendency to extrapolate a few years of impressive growth endlessly into the future-i.e., since housing prices doubled in the last five years, they'll do so in the next five.) In October 2007 the top of the global bull market, McKinsey & Co. issued a report about private-equity firms and sovereign wealth funds fueled by petrodollars and Asian exporters.

The New Power Brokers, as McKinsey dubbed them, had about $8.4 trillion assets in 2006, a number that had tripled since 2000 and "which could double in five years." McKinsey estimated that oil-related SWFs alone had more than $2 trillion, with the Abu Dhabi Investment Authority alone playing with $875 billion. In no time, McKinsey suggested, the newly formed China Investment Corp. would have $300 billion, Korea's SWF would have $100 billion and Singapore's Government Investment Corp. $300 billion. According to this report from early 2008, Simon Johnson, then the chief economist at the International Monetary Fund, believed SWFs' assets would rise to $10 trillion by 2012, while Jen of Morgan Stanley believed they'd rise to $12 trillion by 2015.

As you've probably guessed, the projections haven't quite materialized. The SWFs, it turned out, have been felled by the same forces that have brought down so many other investors, including private equity and hedge funds-a reversal of economic trends that propelled them to prominence and poor decision making. The volume of world trade fell 11.3 percent from the fourth quarter of 2008 to the first quarter of 2009, which means fewer dollars were flowing into the coffers of Asian central banks. The price of oil has plummeted by two-thirds since its peak last year, while demand has slackened, which means fewer dollars for Persian Gulf states. SWFs have also proven to be poor market timers, as many of them plunged deeply into stocks in 2007 and 2008, and were effectively taken to the cleaners by American financiers. Singapore's Temasek just sold at a huge loss the stake in Bank of America it had acquired via a $4.4 billion investment in Merrill, Lynch. The Abu Dhabi Investment Authority in November 2007 invested $7.5 billion in Citigroup, buying preferred stock convertible into common stock at prices in the mid-'30s. Citi's stock today trades for less than $4. In March 2007, China Investment Corp bought $3 billion in stock of Blackstone, at about $28 per share. Today, Blackstone trades at about $11 per share, meaning China's down about 60 percent on that investment.

A new report by the Monitor Group quantifies just how much SWFs have fallen. Data crunched by Bill Megginson of the University of Oklahoma and other researchers showed that the funds have lost "at least $57.2 billion on paper from their initial investments." Monitor concludes: "This SWF performance is driven primarily by their large exposure to the financial services sector, but also likely due to unfortunate stock picking or a tendency to invest in distressed industries as a way to minimize political or PR opposition." And so the asset class that two years ago seemed poised to take over the world, is contracting. Monitor concludes that the globe's 31 SWFs, spread among 23 countries, have total assets of $1.8 trillion, and that many have shrunk. The Abu Dhabi Investment Authority has $282 billion (about one-third McKinsey's 2007 estimate). The China Investment Corp. has $190 billion (not $300 billion, as per McKinsey), and the Korea Investment Corp has $20 billion.

Of course, we shouldn't compound the error of extrapolating from recent results endlessly into the future. The SWFs' $1.8 trillion still represents a significant chunk of change. And once the world's downward economic spiral is halted, commodity prices and the volume of trade will start to grow again. Who knows, in three or four years, they may even be worth $3 trillion!